Abstract
How should small states formulate a countercyclical fiscal policy to achieve economic stability and fiscal sustainability when they are prone to natural disasters, climate change, commodity price changes, and uncertain donor grants? We study how natural disasters and climate change affect long-term debt dynamics, and we propose cutting-edge fiscal policy rules. We find the primacy of a recurrent expenditure rule based on non-resource and non-grant revenue, interdependently determined by government debt and budget balance targets with expected disaster shocks. This innovative fiscal rule is classified as a natural disaster-resilient fiscal rule, which comprises a plethora of new advantages compared to existing fiscal rules. This new type of fiscal rule can be called as the third-generation fiscal rule. It encompasses natural disasters and climate change, uses budget data only, avoids the need for escape clauses, and operates on a timely basis. Our rule-based fiscal policy framework is practically applicable for many developing countries facing an increasing frequency and impact of devastating natural hazards, and climatic change.
Highlights
How should small, fragile islands formulate fiscal policy when vulnerable to various shocks such as natural disasters, climate change, commodity price fluctuations, or uncertain donor grants? Fiscal policy rules help mitigate the effects of such shocks on the economy
We chose PNG because it is the largest economy in the Pacific Islands, it has all characteristics of the region, and we have available data for our analysis
Fiscal rules (the recurrent expenditure rule based on non-resource and non-grant revenue defined in Equation (12); the natural disaster-resilient fiscal rule incorporating debt and budget balance targets in Equation (14); and the linear budget balance adjustment rule presented in Equation (10)) are different concepts, they are closely interconnected in our natural disaster-resilient fiscal framework
Summary
Fragile islands formulate fiscal policy when vulnerable to various shocks such as natural disasters, climate change, commodity price fluctuations, or uncertain donor grants? Fiscal policy rules help mitigate the effects of such shocks on the economy. Fragile islands formulate fiscal policy when vulnerable to various shocks such as natural disasters, climate change, commodity price fluctuations, or uncertain donor grants? We develop an analytical framework for a rule-based fiscal policy to ensure fiscal sustainability and economic stability in countries most prone to natural disasters, with a focus on the Pacific Islands. Automatic stabilizers are located on the expenditure side in advanced countries [15] This is applicable to the Pacific Islands because countercyclical fiscal policy is mainly caused by inertia in discretionary expenditure: governments do no lay off officials, teachers, policemen or nurses during economic downturns, some expenditure items that contribute to countercyclicality such as social insurance and unemployment benefits are not well developed in small states compared to advanced countries. Operational simplicity is preferable when designing the fiscal rules for the Pacific Islands, given their institutional capacity
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